This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Growth Investing Works
On Tuesday, I introduced the Profit & Protection playbook — a good, hard look into beating the markets with data.
The big takeaway from that newsletter?
Growth investing works.
Stocks with high expected growth rates (both sales and earnings) and past growth tend to outperform over the following twelve months. That’s no news to venture capitalists or my Hypergrowth Investing colleague, Luke Lango.
But there was a wrinkle:
Turnarounds do even better.
Stocks that had the worst sales growth in the prior year outperformed their high-growth counterparts by a 1.4-to-1 ratio.
I can practically see Warren Buffett and InvestorPlace analyst Eric Fry smiling.
But if you’re tired of all this theoretical fluff, I don’t blame you. We’re here for profits, not a lesson in data science or fortune-telling.
So today, we’re going to use the Profit & Protection playbook to identify five promising growth stocks that look set to ride out the upcoming 6 to 12 months.
The Five Growth Stocks to Buy Now
The “Growth” section of the Profit & Protection playbook threads a fine needle. On the one hand, we want stocks that have high projected growth. As mentioned on Tuesday, companies with the fastest expected growth outperform the slowest ones.
We want companies cut from this high-growth cloth.
But on the other hand, we also want to include companies that have stumbled in the past. Companies like AT&T (NYSE:T) eventually become so cheap that the only direction these blue-chip earners can go is up.
Threading a fine needle, indeed.
Once again, we can turn to the data to get us started. By running the system in reverse, the Profit & Protection playbook picks out the highest-potential stocks that look much like past winners.
Stock-Picking Vs. Pure Quant
The Profit & Protection system immediately spits out a list of potential stocks from the A+ range…
- Frontline (NYSE:FRO)
- iCAD (NASDAQ:ICAD)
- Seagen (NASDAQ:SGEN)
- Nordic American Tanker (NYSE:NAT)
- Patterson-UTI Energy (NASDAQ:PTEN)
…Some A’s and A-minuses…
- Bed Bath & Beyond (NASDAQ:BBBY)
- Sabre Corp (NASDAQ:SABR)
- Shake Shack (NYSE:SHAK)
- First Solar (NASDAQ:FSLR)
- HubSpot (NYSE:HUBS)
…and so on.
If we were algorithmic traders churning through hundreds of tickers per day, the story could end there. A system that produces 7% to 10% annualized returns can be leveraged to return 20%…30%…40%… or any expected number given a particular set of risk constraints.
But we’re here to pick a smaller portfolio and trade less often, not more.
To do that, I conducted a secondary screen of my stock-picking system. Companies like Patterson-UTI Energy — which have excellent growth profiles — are eliminated because of other factors (in PTEN’s case, because its energy-fueled growth is only temporary and shares haven’t priced in the eventual decline).
Promising ones like those listed below are elevated.
Growth Score: B+
Qualitative Score: A+
Early Profit & Protection readers will quickly recognize Etsy (NASDAQ:ETSY) — one of this newsletter’s top picks. And digging through the data, it’s easy to see why.
This ecommerce site for handmade goods has been a work-from-home darling. Revenues doubled in 2020 during the pandemic, adding to its consistent 35% growth rate from prior years. Gross profits have also grown from the mid-60s% to 72% as the firm has nudged up its seller fees.
And the best part?
Analysts expect Etsy to keep growing.
Current Street estimates now project average revenue growth of 16.3% through 2024. EPS should double from 2022 rates. That puts Etsy squarely in the top 15% of all companies for future growth.
There are however some downsides. Shares will likely fall over the next three to six months as consumers continue to shun tech stocks. The firm’s pricey $1.6 billion acquisition of fashion marketplace Depop has weakened its balance sheet at an inopportune time. And unexpectedly slow growth in 2021 has given many investors some pause (though it’s a good indicator of turnarounds).
Still, Etsy is a company that I would happily “buy the dip” for a longer 12 to 18 month holding period. The ecommerce site’s wide moat in handmade goods makes it a more durable play than race-to-the-bottom firms like ContextLogic (NASDAQ:WISH) that sell cheap, interchangeable imports. And strong cash flows give Etsy protection from bankruptcy.
The Profit & Protection playbook also unearths some new names this week.
- ZScaler. Analysts expect ZScaler to add another 56% to its revenues this year and 36% the next, putting the firm in the top 10% of growers.
- CrowdStrike. The larger endpoint security firm is expected to grow at an enviable 48% next year to top off its last year’s 66% rate.
Both companies are trading at abnormally low valuations. ZScaler now has a 95% upside, according to analysts at Morningstar, and CrowdStrike has a 56% one.
We’ll dive into more details in tomorrow’s newsletter.
The cloud-based communication-platform-as-a-service (CPaaS) is one of the leaders in migrating firms to software-based communications. It’s a high-growth industry — analysts expect sales to reaccelerate later this year, and for TWLO to reach profitability by 2023.
The firm’s recent slowdown (from tough comps) has also made shares cheap. TWLO trades almost 80% below its 52-week high, making for an appetizing comeback play.
And finally, meme stock Bed Bath and Beyond earns a surprising “A” grade for its Profit & Protection growth score.
Apparently, even human intuition has its limits.
In short, BBBY scores surprisingly well because the Profit & Protection strategy recognizes turnarounds. Sales of the home goods retailer fell -17% in FY 2021; the firm went from $57 million in net income to a -$123 million loss that year.
Meanwhile, future growth is expected to reaccelerate. Analysts are now forecasting a 74% increase in net income in 2024, placing the retailer’s EPS growth on a similar track as tech firms like ZScalar.
In short, it’s the best of both worlds from a quantitative standpoint.
There are, however, many reasons why conservative investors will want to stay away.
Firstly, BBBY’s other Profit & Protection factors — including momentum and earnings quality — are lagging (we’ll cover these elements in the coming weeks).
Secondly, stocks like Bed Bath offer virtually zero downside protection, as retailers from JC Penney to Sears (SHLD) have shown.
Investors could lose everything.
And finally, there’s no guarantee that activist investor Ryan Cohen will be successful in revamping the company’s direction.
But for every dozen retailers that go to zero, there’s a handful that return 2x… 5x… or even 10x. Just ask anyone who bought shares of Boot Barn (NYSE:BOOT) or Big 5 Sporting Goods (NASDAQ:BGFV) in the past five years.
Remember, when it comes to using The Profit & Protection system, it’s about raising the overall probability of success, not about scoring a 100% hit rate.
Do Growth Strategies Always Work?
Earlier I published a graph showing that Wall Street EPS estimates are particularly surprisingly strong predictors of future returns.
But there was one year that didn’t happen: 2019.
That year, low-growth stocks outperformed their high-growth counterparts by 5.7%.
“It was a year filled with fears that were never realized,” wrote Al Lewis at CNBC. “Much of the stock market’s gains in 2019 can be attributed to a dramatic policy shift at the Federal Reserve… when after a change of heart the Fed lowered rates three times.”
Rate-sensitive stocks like the REIT Summit Hotel Properties (NYSE:INN) would see shares rise by a quarter, despite muted growth prospects.
But the data also shows that long-term investors are better off avoiding these bets. INN would give up virtually all its gains the following year, while high-growth companies like Zoom Communications (NASDAQ:ZM) soared instead.
The Profit & Protection system isn’t perfect. You can still lose even when the odds are stacked against the house. But given a choice between randomness and having an edge, investors should opt for the latter every time.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.